Market failure, failure of a market to deliver an optimal result. In particular, the economic theory of market failure seeks to account for inefficient outcomes in markets that otherwise conform to the assumptions about markets held by neoclassical economics (i.e., markets that feature perfect competition, symmetrical information, and completeness). When failure happens, less welfare is created than could be created given the available resources. The social task then becomes to correct the failure.

The theory of market failure is at the heart of several economic analyses that support government action (intervention) in markets for goods and services or that justify outright government production. Many social welfare programs find their theoretical justification in market failure or in other violations of the standard market assumptions.

Criticism of the market failure notion and of using government to remedy market failure’s effects has been articulated in the public choice school of economics. Public choice scholarship has had great impact on contemporary reforms of the public sector, replacing the Keynesian economics logics that drove much public service expansion. Such critiques have led to reforms seeking to replace governments with markets to challenge or remedy market failure.

The theory

The descriptions of market failure were developed in the middle of the 20th century as part of a larger school of Keynesian welfare and macroeconomics. Important contributors included Arthur C. Pigou, Francis Bator, William Baumol, and Paul A. Samuelson. Those theorists were concerned with the correspondence between free market outcomes and social welfare optimization. In standard economics the “invisible hand,” or duality, theorem holds that laissez-faire market performance and Pareto optimality go hand in hand. When consumers and producers respond to price signals, they make their own decisions about whether to buy or sell and how to produce the good. The aggregate of those choices is the same as the Pareto optimal, or socially optimal, distribution. Pareto optimality—which takes its name from Italian economist Vilfredo Pareto—is attained when it is impossible to find an alternative that would make one actor better off while keeping all others as well off as before. Welfare economists were concerned with conditions under which that correspondence failed and sought to describe such conditions.

The interest in exceptions to the invisible hand theorem led to the study of violations of the standard market assumptions. Those assumptions include perfect competition, perfect information, complete markets, and the absence of market failures. Markets fail under any of three conditions: production has increasing economies of scale; goods in the market are public; or production or consumption has externalities.

Increasing economies of scale

When producing one more of a good leads to a lower average cost of producing each good, production of the good has increasing economies of scale. Economists have found that when economies of scale increase regardless of how much is produced, few or no firms can survive as producers in the market. The standard concern with increasing economies of scale is that market forces will lead to monopoly production. Monopolies are sole providers of goods in a market, so they can charge any price they find suits their needs. Economists find that this leads to a suboptimal level of production and consumption. In addition, increasing economies of scale may push all producers out of a market if none can charge enough to cover costs. In that case, production ceases even if it benefits society. Hence, markets fail under increasing economies of scale.

Historically, several services necessary to running a modern economy were considered to have increasing economies of scale. Such services were often thought of as natural monopolies, because free markets would create monopolies from them. They included telephone and other telecommunications services, postal services, and electrical and water utilities. From the early 1980s, however, the proposition of increasing economies of scale was challenged for those types of services.

Public goods

Public goods are socially beneficial but are almost never produced by free markets. Three attributes of a good render it public. One is that no person can be excluded from using the good (nonexcludability). Another is that one person using it does not prevent another from using it (nonrivalry). The final attribute is that no person can reject using the good (nonrejectability). When a good has these attributes, no single individuals will pay for the good unless they gain so much utility from it that they can pay for the entire cost of producing it. This is because individuals can enjoy the good without paying for it—they can “free ride” on those who pay for it and “shirk their duty” to pay without losing the good. So in all but exceptional cases, public goods will not be produced by the private market, even though substantial parts of society benefit from having them.

Classic examples of public goods are streets, parks, national defense, broadcasts, and lighthouses. To use national defense as an illustration, whether or not citizens pay for it, the national armed forces will provide defense for them. Foreign invasions are denied, providing a benefit to each individual. But because individuals benefit regardless of whether they pay, few are likely to pay if they have a choice. If defense were a good in the market, it would earn no revenue, because no one would have to pay to enjoy it. But providing defense is costly, so no producers would undertake the task, because they could not make money doing so. The market would then fail. There would be no national defense, even though such defense is arguably socially optimal because it deters armed invasion.

Externalities

When goods are produced, they may create consequences that no one pays for. Such unaccounted-for consequences are called externalities. Because externalities are not accounted for in the costs and prices of the free market, market agents will receive the wrong signals and allocate resources toward bad externalities and away from good externalities.

Good externalities are consequences that benefit society. However, because those benefits are not accounted for in the price of the good, the price is higher than it should be, and too little of the good is consumed and produced. Bad externalities harm society. However, because the costs of those externalities are not accounted for in the price of the good, the price is lower than it should be, and too much of the good is consumed and produced. In both cases, the market has failed to reach efficiency, because it has allocated resources and production without considering the externalities.

Classic examples of bad externalities include industrial pollution and traffic congestion. Industrial pollution has harmful effects on people and the environment. Yet the cost of producing goods does not include the cost of dealing with the effects of pollution. This means that, in the free market, producers are responding to costs that are too low, and consumers are facing prices that are too low. More goods are produced and sold in the free market than should be, given the negative social effects of pollution.

An example of good externalities is private home renovation. Renovation has a beneficial effect beyond the renovated home, because it increases property values in the neighbourhood. But such benefits are not included in the home owners’ calculations in a free market, because their neighbours do not pay them to renovate. As a result, fewer home owners renovate in the free market than the beneficial social effects would justify.

Historical remedies for market failure

In practice, the discovery of market failure helped arguments for sustaining government production, expanding social welfare programs, and market regulatory action in the 1960s and ’70s. If the goal is to achieve social efficiency and if markets cannot provide it alone, the next step is to find a supplement to help the market or even to replace it as the means of distributing resources. The common thread in many polities was to remedy market failure with government-based initiatives.

Government has significant capacities that have been applied to counter market failure. Public goods can be produced by the government for the benefit of all citizens. Government can impose and collect taxes to pay for the goods so that no free riders or duty shirkers can sustain their behaviour. The government can impose costs for negative externalities through taxes or fees on individual producers and consumers and encourage positive externalities through tax breaks or subsidies for the market agents. Monopolies can be regulated to limit price excesses or production can be encouraged through subsidies when a product has increasing economies of scale.

Welfare services, including education, child care, elder care, and health care, are considered by many welfare theorists as sectors where markets fail. Suboptimal distribution of access to these services in free markets is most often at the heart of these arguments. Here the suboptimal outcomes may be that some citizens cannot access welfare services or that the welfare service levels available are not the same for all citizens. In place of markets, government can mandate or directly provide access for all citizens, and it can regulate or directly produce the desired level of service.

The post-World War II era saw dramatic expansions of government-based welfare service programs in most industrialized countries. The extent and character of programs vary considerably. But common to them is that they have constituted a major part of government activity, including spending and public employment, since the late 1960s in even the least expansionary countries, such as the United States. This scale and scope have made welfare programs a prime target for government reformers, fiscal conservatives, and critics of welfare economic theory.

Contemporary reforms and market failure

The practical critique of welfare economics challenges the reliance on governments to remedy market shortcomings. This critique is often associated with public choice theorists and the Austrian school of economics. If markets can fail to deliver socially optimal outcomes, so can governments. Bureaucrats are not altruistic but, rather, act from self-interest. Traditional civil service processes are opaque and make bureaucrats unaccountable for their actions. Incentives in the civil service promote decisions that are incompatible with efficient production. These attributes of civil services lead to more inefficient production than open market conditions would yield. Markets may fail, but governments fail more. So if market failures are to be solved, these critics argue, government is not the answer.

Reforms of the public sector, in particular the variety developed in Britain and New Zealand in the 1980s, have relied on public choice scholarship for inspiration and guidance. Privatization, contracting out, and rationalization of public administration have changed how governments act to deal with market failure. The general trend in these reforms has been to introduce markets to alleviate the shortcomings of government controls while questioning or eliminating the conditions for market failure.

The most significant changes have probably been in how governments understand increasing economies of scale production. That telecommunications, utilities, and postal services were increasing returns to scale across all levels of output was challenged in the early 1980s. Before that, the consensus throughout the industrialized world was that they were. Hence, leaving production to the free market was considered inefficient because it would result in monopolies or no production at all. That logic could justify governments’ either owning these producers or tightly regulating their pricing and structure. But in the early 1980s that consensus ended, and governments throughout the industrialized world began to sell their stakes in such operations in whole or in part or break up regulated private monopolies. In addition, evidence indicates that governments significantly increased their roles in market regulation in place of exercising ownership control. In general, governments came to focus on setting the terms for property rights and competition. Pricing and production levels were left to individual firm and consumer decisions in the markets.

Other initiatives sought to introduce markets in place of government to deal with externalities. One was to make markets in air pollution rights in place of limits, taxes, and fines on individual producers. The 1990 amendment to the U.S. Clean Air Act introduced sulfur emissions rights, a market for trading them, and a total allowable level of sulfur emissions. The amendment set limits on the total allowable levels of sulfur in the air. It distributed tradable discharge permits (TDPs) for sulfur among existing polluters. The act also implemented the allowance trading system, which lets polluters sell or buy pollution rights from one another. In the period up to 2000, the U.S. government gradually decreased the total allowable level of sulfur emissions but left the negotiation and distribution of the impact to market decisions by polluters. That reform attempted to transform sulfur pollution from an externality to a part of the cost structure of individual sulfur emitters.

Finally, goods traditionally considered public have been reconsidered. A prominent example is inner-city road pricing in London, England. There technology affected the nonexcludability of public streets. Access to city streets remained physically unrestricted, but, by electronically registering the cars that use the streets and charging the car owners, London was able to charge users for the privilege, effectively excluding drivers unwilling to pay. London streets are no longer strictly a public good.